Here is what happens during an IPO (Initial Public Offering): the company that is getting listed in the stock exchange, offers its shares to the public for purchase.
This is usually done through underwriters, who regulate the process. Underwriters often commit to taking up some shares of the company, if they aren’t fully bought by the public. But what happens if the shares issued by the company are not sufficient? That’s where the green shoe comes in.
What is a green shoe option?
The green shoe option is a provision that gives permission to the underwriters involved in an IPO allotment process, to sell additional shares to the public, in case there is a surplus of demand over supply. It sort of works as a safety net, to ensure that the market demand is met.
The green shoe option can actually help the stock price in becoming stable. This happens because of an increase in the supply of shares. The additional shares help prevent the price of the stock from shooting up due to a demand-supply gap.
Fun fact: The name “green shoe” comes from the first ever company that used this option in 1960, Green Shoe Manufacturing.
Key features of green shoe option
1. Flexibility
This option offers flexibility to underwriters, and allows them to adjust the size of offering. This is done based on the demand received and the market conditions.
2. Stabilization
The Green Shoe Option increases the number of shares which helps stabilize the stock price after the IPO happens. This is vital for controlling volatility in the market and maintaining equilibrium.
3. Price Support
If and when the stock price reduces and falls below the offering price post-IPO, the green shoe option can be exercised to buy back shares. This supports the price and protects investors’ interests.
4. Market Confidence
The presence of this option alone can bring confidence in the market, as it signals the possibility of an increased offering size in case the market demands it.
5. Historical Precedence
Many IPOs have benefited from utilizing this option and historically this has set a precedence for later IPOs.
Importance of the green shoe option
1. Market Stabilization
Maintaining a stable trading environment and controlling market volatility is vital to a healthy market and the green shoe option plays a key role in this regard. IPOs can threaten market stability in a number of ways, and the green shoe option regulates offerings to dilute this threat.
2. Meeting Investor Demand
The green shoe option enables underwriters to take the liberty of expanding offering size in order to meet the surplus demand received from the market. Meeting market demand for shares is important for keeping investors happy.
3. Price Support
In case the market demand doesn’t match the supply, it would result in the fall of the stock price below the offering price. In such circumstances, the underwriters buy back some shares in order to support the price and prevent further fall.
4. Enhancing Offering Value
The potential rise in the number of shares that comes with the green shoe option increases the value of the IPO, since this boosts the confidence levels in the market. Adding this option to an IPO is a good way to raise expectations.
5. Adaptability
The flexibility and adaptability that green shoe option brings to an offering are immense. The offering size can be adjusted by the underwriters to fit the market demand and conditions thereby enabling an optimal allocation of shares.
6. Standard Practice
Owing to its many benefits and proven track record, the green shoe option has become a standard feature of many IPOs. This has become so popular that the absence of this feature can raise doubts and queries in the minds of the investors. There might even be a subtle pressure for companies to include the option to their IPO.
Conclusion
The green shoe option is a simple yet strong addition to an IPO, as it can solve multiple problems. As an investor, it would help to note if an IPO includes this option or not, when one considers investing in the stock.